Not only is the recent data disappointing, but the overhang of shadow inventories threatens to keep the housing market depressed for some time to come.

We’ll begin with a look at the data. Existing home sales were down 2.6% in March, the second straight monthly decline. Sales remain depressed, and are still 37% below the peak during the boom. The purchase index for the latest reported week was down 11%, and is down 15% from a year earlier. New housing starts dropped for the second consecutive month to a paltry 654,000. It topped out at 2,273,000 in January 2006. The NAHB housing index for April dropped back to its early January level. It remains at 25, compared to a peak reading of 70. The latest Case/Shiller report show year-over-year national average price declines of 4% To find anything encouraging in these numbers is quite a stretch.

In addition to the data already reported, it is difficult to be optimistic about the period ahead. Although the bulls talk a great deal about the decline in inventories of homes for sale, keep in mind that the official inventory numbers include only homes that are now on the market, and ignores the importance of the so-called "shadow inventories" that loom over the industry like the sword of Damocles. The shadow inventories include houses that are not now on the market, but are either delinquent on mortgage payments, in default, owned by banks or are in some stage of the foreclosure process. Estimates of the number of houses in this category vary anywhere between 2 million and 10 million.

Foreclosures have generally declined over the past year as a result of the well-known robo signing scandal that caused banks to voluntarily stop most foreclosures pending some kind of settlement. This has now been accomplished by an overall settlement between the states’ attorney-generals and the major bank mortgage holders. As a result, the significant number of potential foreclosures that were held back by the scandal will now begin to be processed and show up in future inventories. It is highly likely that the vast number of distressed houses coming into the market will depress prices even more in the period ahead.

Importantly, the shadow inventories do not include homes that are under water, but where mortgage payments are up to date. This group includes homes with mortgages that are now worth at least 5% less than the amount of their mortgage. About 25% of all homes with mortgages now fall into this category, and as prices decline even more under the weight of the shadow inventories, the number of underwater homes will increase, putting even more pressure on prices. Experience indicates that the more a mortgage is underwater, the greater the chances are that owners will stop maintaining their property and quit paying their mortgage.

The bullish argument that houses are now generally affordable also does not hold up on closer examination. As we have repeated ad infinitum the average household has too much debt and is in the midst of deleveraging rather than taking on more debt. Furthermore, households, on average, do not have enough cash for a down payment or a high enough credit score to qualify for the more stringent credit standards put into effect following the credit crisis. Neither do they have enough income. According to Ned Davis Research the ratio of median home prices to median household income is still about 5% above the 36-year mean. It is notable that following all bubble periods, ratios not only decline back to the mean, but fall significantly under it.

All in all, it seems that it will be some time before the massive number of actual and shadow inventories are cleared from the system. Until that happens, home prices will remain under continued pressure.

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The speculation market would disappear with tighter caps on mortgage interest deductions. Limiting individual deductions to one property and one mortgage and even an upper limit on the portion of the mortgage principal for which a deduction might be claimed would reasonably assign the costs and risks of speculation to those engaging in those practices.

As far as the shadow housing inventory, underwater valuations and the like threatening the market, the vitality of the housing market will depend far more on the unemployment rate and and eligibility of buyers to obtain credit. Gun-shy banks, now wanting more traditional down-payments of 20% and conservative valuations of housing stock to avoid the (justifiable) accusations of fraudulent bubble period property over-valuations will all result in less bidding and probable non-market/market failure where sellers needing to sell cannot unload at market prices without short-selling.

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